Most, if not all, investors on the ASX love and relish receiving passive income from their shares in the form of dividends. Seeing a dividend payment arrive in your bank account is hands down one of the best feelings after starting an investing journey. Not only is it cold hard cash that you are banking, but it also represents a tangible affirmation that investing is a tried and true method of building wealth.
But an obsession with using shares to build passive income can also be deleterious to your overall returns. After all, dividend income is only one way we can receive investing returns from shares. The best investors know that a company that pays all of its cash out as dividend income is leaving little on the table to actually grow its business and ensure that dividends keep coming.
Passive income from ASX shares?
We also want to aim for companies that want to reinvest for growth and provide the best returns for their shareholders over the long term, not just a high level of dividend income today.
The ASX has just released its 2023 Australian Investor Study. It sheds some light on what is currently driving young investors when it comes to investing their money.
The report analysed the main goals of a selected group of investors, taken from a wide range of ages. It found the 'next generation' of investors, aged between 18 and 24, were the most likely out of all age groups to pursue passive income on the share market.
In fact, 36% of these next-generation investors identified 'building a sustainable income stream' as their top investment priority, more than any other age group (including pre-retirees and retirees). The report notes that "this is unexpected considering younger investors still have the option of an income stream from work".
Just 19% of those next-generation investors selected 'maximising capital growth' as their main goal.
This is indeed unexpected, although not entirely surprising. As we discussed above, passive income in the form of cash dividend payments can give us a pleasing reminder that investing in shares can provide immediate, tangible returns. Perhaps these younger investors are responding to this immediate return by chasing ever-increasing passive income.
When is dividend investing not the best path to take?
However, this might not be the most lucrative path to chase. Dividends are fantastic, but they probably shouldn't be a priority for investors who don't necessarily need a secondary source of income immediately.
To illustrate, let's take two hypothetical investors, John and Jill. John invests solely for passive income, building a portfolio that returns an average of 4% in dividend income returns every year, with an additional 2% in capital growth. Jill instead invests in a portfolio more geared towards growth. She nets an average of 2% per year in dividend returns while enjoying 6% per annum from capital growth.
If John invested $10,000 into his portfolio, he would have a grand total of $33,102 after 20 years (assuming he reinvested his passive dividend income back into additional shares over this period). Jill on the other hand would have a total of $49,268 at the end of the decade at her superior rate of return of 8%.
So even though Jill is receiving less passive income than John, she will be far better off financially by prioritising capital growth ahead of dividend income. Jill can then move her larger nest egg into higher-yielding dividend shares when she is ready to retire, and receive more passive income than John could.
This comparison doesn't take into account the fact that John would also be paying higher taxes on his returns over the two decades, thanks to the tax treatment of dividends. Conversely, Jill will have to pay less tax over this timespan, as capital gains are not taxed until the shares are sold.
Foolish takeaway
We all have different investing strategies, goals, and life circumstances. However, this shows how prioritising dividend income over all else might not always be the best way to invest, particularly for young people with decades left in the workforce.
